This is part 1 of the 5 episode “Back to the Basics” series from The Investing for Beginners Podcast. Each episode covers the fundamentals of the stock market and investing to provide a solid foundation for those who are looking to compound their wealth over time.
Here are the links to each of the episodes:
Back to the Basics Pt 1: The Anatomy of Stocks and Shares
–Defining what a stock is
–Talk about the big 3: the cash flow statement, balance sheet, and income statement
Back to the Basics Pt 2: Share Dilution on Wall Street
–What is a stock
–What are stock buybacks and how they affect us
–What are share dilutions
–What happens when we buy or sell a stock
Back to the Basics Pt 3: Stocks vs Other Investments
–Peer to peer lending
–Gold and other precious metals
–Bitcoin and other cryptocurrencies
Back to the Basics Pt 4: Investing 101 and Compound Interest
–The importance of buy and hold
–Compound interest and how it can make you wealthy
–Using a compound interest calculator
–The power of dollar cost averaging
Back to the Basics Pt 5: Dividend Stocks and Value Investing
–The advantages of buying low and selling high
–Dividends and the power of compounding
Dave: Welcome to Investing for Beginners podcast, this is episode 43. Andrew and I are going to be talking about some beginning stuff. As my baseball coach used to say it’s all about the basics and we used to drill it into our heads every single week, but it works it helped us a lot we were a good team, and we won a lot of games, and so it was awesome.
- Defining what a stock is
- Talk about the big 3: the cash flow statement, balance sheet, and income statement
- Earnings manipulation
So I think going back to the basics is always a great thing and you can never know enough, and it’s always good to just learn the foundation and kind of build from there.
Andrew: yeah let’s talk about stocks. I mean if there is a way to change the archive so this would be the first one. And people would just kind of follow a progression that would be awesome and hopefully this is an episode that we can reference in the future and tell people hey if you’re completely beginner and you want to understand how the stock market works and why it works the way it does and what it all means from the most basic perspective.
Hopefully, this episode will cover that so basically you know we talked about this a lot how a stock is part owner of a company. But you know what does that mean exactly what is the stock market at all and then you know why it even they exist is.
So you have to think about the way the business world works for a minute, and I’m not going to use the lemonade example because I feel like everybody uses a lemonade stand. So let’s say you have a coffee shop it’s very successful you got the line up the door and demands high to grow the business.
You have a couple of options as the business owner; you can use cash which might take a little while because you need to collect more cash save it up and use that to build a new store or in your shop or whatever or you know you could go the bank get a loan.
I have to pay interest on that loan, and then you could buy a store right away, or you can do what these public companies are doing now in the stock market where you’re giving ownership away of your business to get cash. And so what’s nice about that is it can get you a lot more cash as a business then you can get from like a business loan.
It creates explosive growth, so we’re regular growth and growth from cash might be kind of linear and limited. This can give you when we talk about compound interest when stuff is exponential, and things just blow up out of proportion.
If you ever watched Shark Tank, you’ll see that to you know these investors want to see substantial growth and they want to make sure that their money’s going to multiply really.
Now we see these different ways that businesses can fund and grow. Why would an investor want to give the business cash, right?
If you were an investor it would be nice to get a guaranteed return so you could be like the bank, and you could give away cash and just get a set interest rate. But what makes giving cash away for part ownership so appealing is that you’re doing it in the hopes that the business will make that explosive growth that the business owner is promising and what that will do is grow that cash that you gave them that they’ll be able to return that back in dividends.
The investors will give that cash to the business, and the business is going to grow and to whatever scale that the business can grow that investor will see their capital grow as well.
Obviously you know if the business can triple and growth and triple in its real value, then as an investor and some of the who’s part owner you’re going to see the value of that money triple as well. That’s on the basic scale of kind of how the business world works and as it relates to giving away part ownership giving away shares and how the stock market creates wealth.
Business owners have a problem, and that’s lack of capital– but you know they might have ways to create capital. They might be short on time and they want to accelerate the growth. And investors have their issue, right, like they have capital but they don’t necessarily have the resources to make that capital grow or have to make it work.
It’s a real symbiotic relationship and it works really well, and it’s really a primary driver of how capitalism works so well.
You see this relationship and then you get to the Wall Street level. It’s the same thing basically on steroids. It’s just trillions of dollars of capital floating around, and it grows at such a big scale and it could make a lot of people wealthy.
With the pension funds, yes, nowadays we talk about how they’re not really around anymore but you still have pensions for the teachers and the firefighters and the public service people… and where are those pensions coming from?
Well, they’re coming from the stock market. They’re coming from businesses around the country and the world that are making profits. You look around it’s the McDonald’s, it’s the Walmart, it’s all these businesses that we’ve seen, and they’ve been around for such a long time, and it’s just a big circle, and it is almost like a circle of life type of deal in a sense.
And I think it’s a big part of what the stock market really is and it’s so integrated into everybody’s life it’s just work because there’s no education there’s nobody explaining how like the system kind of works then we’re not aware how much of a part of it we are and how much we can benefit from it.
One way that the general public kind of benefits from the way the stock market works and the business world works is, like I said, with the pensions. But another way is if you take the initiative yourself, and you open the 401k you open an IRA you buy some stocks yourself and all of a sudden now you’re on that you’re on that team of along with the business and then they’re going to grow profits and do things and you know create caramel macchiato and… I didn’t pronounce that right.
Obviously I don’t order those, but you know that they come out with these new products and these innovations, and as a fellow shareholder you can benefit from all those things and so it really is a bunch of people around the globe kind of all teaming up. Maybe not so much aware that they are teaming up, combining resources and doing more together than any one person can do alone, but that’s really what it is.
When you get down to the very root of what the stock market is– what a stock is and what investing is and how it creates money, it’s not just this magical thing like a coin slot where you put money in and five nickels come out. These are the things that are working behind the scenes, and if you can understand that then it can give you more confidence to kind of move forward.
So I think there are so many different ways it kind of works but you know I really do it’s a big part of our lives and it’s something that can really benefit it if we take that step and try to learn at least enough to make progress with that.
Dave: question for you– so if you buy a stock of McDonald’s does that make you an owner of the company?
Andrew: Technically, right? I mean you’re part owner in a way– you obviously don’t control the whole thing– but yes that’s what having shares is. As a part owner you are entitled to the earnings that the company makes.
At the most basic level, a company will pay part of their earnings out in what’s called a dividend. Those are cash payments that you get, and as long as the business is alive and you’re holding shares you’re going to get those cash payments. What’s beautiful about it is that oftentimes these dividend payments grow over time.
So if you “partner up” with a strong business like a McDonald’s or a Walmart or y any of the major companies that are out there, you can have an income stream (and you know we talked about this a couple of weeks ago with The Richest Man in Babylon).
The author really goes in-depth into creating income streams and how that’s a key to building wealth. So each little dividend stock you buy is going to give you an income stream, and as long as that company stays alive that income stream could potentially be growing.
Then you could be taking those dividends and kinda planting seeds everywhere and multiplying the number of streams that you have coming in– and it can really make a big difference your wealth and your standard of living and all of those things.
But you have to start somewhere, and to get a sense of how the stock market works and what stocks are is definitely the first step, and it’s something you can’t really skip. But there’s so much potential as you move forward from that.
You get as a shareholder, or stock owner of you know ‘s say McDonald’s to keep you know using them so I understand you get a dividend from it and you know you mentioned earnings so let’s talk a little bit about that what’s what is that.
At the most basic level earnings is going to be the difference between what a company brings in and what it pays out to bring that money in.
Think of a McDonald’s, right, you have money that they’re getting from the customers coming in.
McDonald’s has to pay for a lease on the property to have their restaurant on there. They have to pay for workers, they have to pay for the buns, the burgers; they have to pay for commercials…
Take however much money they bring in from those cash registers on any given day, and then you subtract how much they paid out just to keep the business running– and that’s going to give you your earnings.
Earnings are just another nice way of saying profit. What’s nice about it as beginners is we can look at how much a company is earning, and we can look up that information from air for every company that’s on the stock market.
It’s all available, and there’s like three main metrics that you want to keep in mind: you have Earnings, you have Book Value, and you have Cash.
So I just explained what earnings is in the most basic sense it’s just a company’s profits you have cash which is the same as cash that you may have in your wallet it really works the same way it’s been convoluted and really maybe convoluted isn’t the right word but it’s really this dissected and really examined at a great amount on Wall Street.
There are so many different things you can do with the cash flow statement, and different analysis is that you can follow, but the gist of it really is if you think about really why with a company have cash and it’s either they want cash so they can go through like a tough time talk about like a McDonald’s again if they have a couple of days where they’re not getting any customers because there’s a rumor about whatever some poison they’re going to need cash to continue paying workers continue paying the lease and all those things to keep the business alive.
In the most basic sense, that’s what cash is for, and then they’ll also want to use cash to grow the business maybe buy it. Buy some land or open more restaurants. Thirdly they would want cash to wait maybe for a business to go on sale and they can kind of acquire the business and grow in that way too. You see a lot of companies doing that especially recently, so you have earnings, you have cash and then the last thing you’d want to understand this book value and that’s just basically what the company owns – what they owe.
So that’s assets minus liabilities. In my mind the easiest way to think of that again is in the personal finance sense where if you have a house the value of that house is going to be an asset for you and then that mortgage that you use to buy the house that’s a liability. so you take the difference, and that’s kind of like your net worth if you add up all the assets and add up all your liabilities that are going to be your net worth for business and the company it’s the same thing their book values kind of like their net worth so the assets they’ll bring in will be things like real estate.
Some companies will, instead of renting out from a business for real estate, they’ll go buy it outright and kind of see that grow in value over time as real estate does. you’ll see them do though they’ll have inventory they’ll maybe they’ll have factories those things are considered assets sometimes they have what’s called intangible assets and things that like company patents or different competitive advantages that aren’t necessarily physical in our physical world.
But they are they do contribute to companies’ profits, so you have those, and then you have liabilities things like you know if a company goes into debt or if they are whatever costs they incur to run the business whether that short term or long term you’ll usually see those show up as liabilities.
You have Book value– you have assets, and assets create earnings and earnings create cash and cash can be given back to shareholders.
All those three things kind of work in a circle, and if it’s working correctly and if it’s all not only having this flow of cash come through but it can accelerate faster. Which is creating more profits, or creating more assets which are creating more cash, which is again creating more assets, which is creating more profits.
And if that’s really spiraling upwards in a very positive sense then that’s going to benefit shareholders as well because now the value of that business that they’re owning if the business’s values going up you’re a little piece of that business value is also going up, and so that’s why you’ll see stock prices and the stock prices will change, and it’s reflective of the business.
It’s not tied to it exactly, but it tends to reflect what the business is worth over the long run and so if the business is growing another really high rate then that price tends to go up as well and that that’s kind of how the whole market thing works and really what’s kind of behind all those different terms that you might hear and when people talk about the stock market they talk about price right and it’s not just some sort of game or it’s not just some made-up thing these are things that are all working in tandem with what’s going on in the business world and what’s going on in real life, and they’re all again circling a life thing.
They’re all affecting each other and these moving parts that create a big picture and again it’s your choice if you want to participate in that or not but for hundreds of years it’s created tons of wealth it’s created explosive growth in the vein of Technology and you would assume it would only even get brighter as the future goes on.
Dave: I like the way you were talking about the circle of life and kind of how they’re all intertwined and you know when you talk about the three kind of categories that you were describing when you describe earnings and when you describe Book value and when you talk about cash they all come from three different statements that we talked a lot about that when you read about a company and their 10k you’ll look at to the income statement which is where the earnings will come from. You look at the Book value which is where it comes from the balance sheet, and then the cash will come from the cash flow statement and all of those flow from one into the other and to the other.
So as Andrew was saying it’s just kind of a circle of life, so you know as the earnings are you know reported then that flows into the balance statement which was flows into the cash statement, cash flow statement excuse me, and the thing that I always find interesting is the Wall Street lists every quarter they have earnings season if you will.
Every three months they will be talking about the earnings of McDonald’s, and they’ll talk they’ll go in ad nauseam about that just a part of it, and it influences the price very much on a short-term basis and you can literally drive yourself crazy by following the companies and reading this and listening to the calls and stuff.
It is interesting to listen to the calls to listen to the CEOs talk you will get a really good sense of the personalities of the people that are involved in running the business that you’re a part owner of and it says it can be a very interesting you know aspect, and you don’t want to throw a little something out there.
I watched a movie on Netflix a couple of months ago about Ray Kroc who was the gentleman who he didn’t start McDonald’s, but he took it to what it is now, and he doesn’t come across as a nice guy in a movie I’m going, being honest with you.
But one of the things that I found really fascinating about it was he realized very early on that the hamburger which was being produced at those restaurants was not the most valuable asset that that company had. He realized very quickly that the real estate that all those restaurants were built on was the most valuable asset.
And that became his focus of expanding. The company was not trying to sell more hamburgers, it was actually trying to buy more land because he realized that that’s where the value of the company could come from.
It’s proven its worth in that thought today and is one of the things that makes McDonald’s one of the most valuable companies in a world, because of all the land that they own. Of course they also sell a lot of hamburgers, french fries and milkshakes and everything else.
But the assets that the company really banks its Book value on is the land that it’s involved with and so you know all these things that Andrew and I talked about there are practical applications that you can use of even companies that you’re very familiar with and you can look at these terms like Book value and you can look at an asset and go what is an asset well an asset is like Andrew is saying it’s laying or it’s the restaurant it’s you know it’s something that’s that can be tangible.
It obviously can be intangible as well, and that’s a whole other conversation but these are things that you can use to help you kind of wrap your brain around these terms that we’re talking about and I find that for me personally it helps me understand some of these concepts when I’m reading about them is to kind of visualize okay uh you know this is when they’re talking about an asset they’re talking about something I could touch whether it’s you know a machine and a factory or whether it’s a computer or whether it’s you know apiece of dirt that a building is built on you know those are all things that can kind of make sense.
So another part of the stock market and I’m not going to talk a lot about this yet because this is something I’m still trying to teach myself when you’re dealing with buying a company you are investing into the aspect of everything that’s involved with a company. So when you buy a company, you’re not just buying the product you’re also buying the people that are running it, and Andrew talks a lot about this in his value trap indicator book.
About the morality of some of the choices that some of these people make like and run for example you know they were immoral men and they did some very bad things, and it cost a lot of people a lot of money and when we talk about risk that’s one of the aspects that were we haven’t really talked a lot about.
But those are one of the some of the risks when you’re investing your hard-earned money in a company you’re also, in essence, taking a chance on the person that’s running that company is going to do right by you. And where I’m referring to as something called an earnings manipulation. A lot of people get caught up in the earnings and the growth of the earnings and follow it kind of like a baseball score. They just they watch it intently, and that’s really what they base their investing style on is simply on the earnings growth or decline of the company and not look at the other aspects of the business.
I think in the future we’re going to talk more about this, but there are companies and people that have done some very immoral things. Trying to raise the share price because that makes them more money because their bonuses are tied on the increase of the stock price and because the stock market is so emotional like Andrew and I have talked about in the past.
That people will get so excited because company a had a great earnings report and all of a sudden it goes up 22% and people get super excited, and everybody wants to jump on the bandwagon and it just keeps driving the price up and up and up when in reality something has been done to manipulate that number it may have been done intentionally it may have done it unintentionally.
But if it’s done intentionally then they may have done that to manipulate the number, so it drives the stock price up which makes them more money and that’s why watching the companies and learning as much about the people that run the company is as important as the numbers behind the company. And knowing about some of these things can help you in the future, and that’s one of the things that I wanted to talk about tonight.
It’s a scary thing it’s a greed part of Wall Street that I mean I did turn a lot of people off especially in 2008-2009, but I think it’s not something to deter you it should be something that we are aware of understanding that not every stock in the exchanges are doing this.
Andrew: actually the way that these statements are audited and the way everything is regulated by the government they can’t get the post office right but at least for the most part they seem to be able to regulate these companies and make sure that these numbers that they’re presenting to the public are audited and accurate for the most part.
Right if not completely, so something maybe to keep in mind as an investor is maybe keep your ears and eyes open we talked about the three statements right the cash flow statement the income statement and the balance sheet. For example, you brought up Enron Dave; I talked about that my value trap indicator book that was a company actually that the way they manipulated their numbers they were able to make their income statement look good but they weren’t able to hide how much debt they were loading up on.
So even though they were able to in a sense manipulate how the numbers worked in one in one aspect they weren’t able to hide it in the other that’s why it’s important not to get narrow focus don’t be like a horse with blinders on the side and just look at one little set of numbers but look at the whole picture.
Right if we have the circle of life we have this sum flow of cat of cash and money and if one little part of its broken and then it’s all going to leak out right. So you want to make sure that the whole picture is that you’re looking at the whole picture and that’s really one big way that you can avoid an earnings manipulation another thing I really don’t want to get too technical and honest to god I always try not to get too technical, but I can’t help myself when you have revenue is something that’s a lot harder to manipulate than earnings because earnings there’s a lot of things you can do with it.
You can say oh well you know I’m paying this employee this much this year and this much of that year and all we have to pay taxes this much this year this much that you’re you can as an accountant you can kind of pick and choose in the sense of where to put those numbers and what years and things like that and it’s still legal.
But with revenue you can’t do that. It’s literally: this is the money that’s coming in, and there’s not much wiggle room.
One way that you can mitigate earnings manipulation is to look at revenue. Another way to mitigate, and you saw the manipulations, is to look at the whole picture and see okay if everything looks nice. Say there’s this one thing that they’ve really mucked up, and it’s really smelly over here, well let’s sniff that out and let’s make sure that the whole thing is solid.
These are just kind of some of the things if you’re first starting now try to get the basics of this understood so that as you move along you’re not blindly jumping into these things that can trip up investors.
Again it doesn’t happen all the time, I haven’t heard of any so sort of earnings manipulation in years, and you know obviously they tend to kind of all pop up around the same time– when all these businesses are crashing and the economy is going through a sort of depression and the stock market is in a bear market.
I think another way is to evaluate management themselves and use that as a basis to avoid these kind of poor situations where you can get your capital taken away like a Bernie Madoff type of deal just because you didn’t do any due diligence on where your money’s going as far as how it’s being used in the stock market.
Dave: exactly no you’re your that was a great way of putting everything and I think that was really what I was trying to go for when I was talking about that I certainly wasn’t trying to be doom and gloom but I just I do want to make sure people are looking at the whole picture, and I think that is, so that’s so important to look at the whole picture and have a kind of your eyes open about everything you know.
As my basketball coach used to say you know dribble with your eyes open and with your head up and I think that’s one of the things when you’re thinking about buying a company is making sure they just you got all your ducks in a row, and you looked at you know you’ve done your due diligence, and you’ve tried really hard to look at all the aspects that you possibly can and make an informed decision, and that’s really what anybody could ever want.
Andrew is right there hasn’t been any earnings manipulations and in quite some time and hopefully, there never will be. But you know I think it’s good for you always to make sure that you’re just dribbling your eyes up with your eyes open and with your head up.
Andrew: I love that obviously there’s so much potential with the stock market and so many things that can be done there’s so much money to remain on Wall Street it’s been done for years I will continue to be done for decades but with the important caveat that yes be careful this is serious business this is your hard-earned cash, and it’s not as simple as just throwing money around and being like oh well I like this company or oh I use this company every day maybe I want to buy that.
It’s not that simple and it’s not as complex as oh I have to interview management and watch what they’re doing from 9:00 to 5:00 it’s somewhere in between that and so be realistic be optimistic and I think the way you put it or I guess your basketball coach put it is really great you know dribble and keep your eyes open and your head up.
Dave: yep I agree so I think without I think that’s going to wrap it up for us for tonight. I hope you enjoyed our conversation of going back to the basics and I think Andrew did a great job of explaining what a stock is and kind of the circle of life so to speak with the big three with the earnings the cash flow statement and the assets and balance sheet the book value.
So I think without any further ado I’m going to go ahead and wrap it up. I hope you guys enjoyed our show you guys have a great weekend we’ll talk to you next week.